My TFSA Update May 2017 - Zargon and Twin Butte Debentures

Last update on June 12, 2017.

Image Credit: zimmytws /


In this series, I (Jin Choi) talk about my goal of reaching $1 million in my TFSA account by 2033. If you want to know what a TFSA is, I recommend you read my free book. In this post, I’ll also recount my experience investing in Zargon and Twin Butte debentures, and I’ll use that experience to explain why I still stubbornly hold onto my oil and gas stocks.


May Results: Down 8.9%

At the end of May, I had $54,330 in my TFSA account, which was down by 8.9% during the month. By comparison, the Canadian stock market went down by 1.2% while the U.S. stock market went up by 0.1% in Canadian dollar terms. Therefore, my portfolio underperformed in May.

The majority of my portfolio currently consists of oil and gas stocks, so the performance of my portfolio should largely be tied to oil. The price of oil went down again from $49.31/barrel to $48.29/barrel at the end of May, and my portfolio suffered as a result.

The decline happened despite the still improving fundamentals. As of the latest IEA report, oil inventories fell by over 30 million barrels in March, implying that there is a supply deficit of roughly 1 million barrels/day.

What’s more, there’s now almost universal agreement that a supply deficit exists, though there’s some disagreement about the amount. Even the IEA, which tends to underestimate global demand, now estimates a supply deficit of 1 million barrels/day. Andrew Hall, who is one of the most successful oil speculators in the world, also estimates a deficit of around 1 to 1.5 million barrels/day.

Furthermore, OPEC agreed to extend its production cuts by nine months, making it very likely that the supply deficit will continue until next year. At this rate, some project that oil inventory levels will fall into median range by the end of this September, which is roughly four months away.

To be fair, there is some reason to be cautious about oil’s prospects. A couple of months ago, I predicted that U.S. inventory levels would go down by roughly 3 to 4 million barrels each week. That prediction has more or less come to pass until the most recent weekly report, which unexpectedly showed a large build in inventories. It’s too early to tell whether this is a one off or whether this is a sign that the global economy is slowing down. I think it’s a one off, but I’ll be keeping a close eye on the weekly inventory reports.

Barring a global economic slowdown, the price of oil “should” reach at least $60/barrel by the end of the summer. I believe $60/barrel is at the low end of a rational price range, given that global production would have a hard time increasing below this price. Indeed, since oil prices went down below this point two years ago, global production has declined slightly.

Thus, even though my portfolio has suffered large declines as the result of low oil prices, I continue to be optimistic about oil in the long term. If oil prices do rise above $60/barrel, I expect my oil stocks to do very well.

However, there’s no guarantee that my portfolio would do well even if oil prices were to rise, if I fail to value my stocks correctly. History is replete with examples where investors correctly predicted something about the future, but lost money anyway. For example, those who bet on internet stocks in the 90s were more or less correct about the huge potential of the internet. But those investors failed to model their stocks correctly, which led them to lose many billions of dollars in aggregate.

So how do we know whether my valuation method is correct? How do we know whether my TFSA portfolio losses are temporary or permanent? While I can’t give any definite proof, there’s some evidence that I’m at least somewhat on the mark. That evidence is my past investment in Zargon and Twin Butte debentures.


Zargon and Twin Butte Debentures

Both Zargon and Twin Butte are small Canadian oil and gas exploration companies. As with many such companies, they both lost a lot of money as oil prices went down. Not only did both companies’ stocks crash, but they saw their debenture prices crash as well.

A debenture is a type of bond that typically ranks junior to other debt. In a bankruptcy, a company would be forced to sell its assets and pay back its debt. The bankers would typically get paid first, followed by debenture holders if there’s any money left over after paying the bankers. The amount of money that debenture holders would receive is called the “recovery amount”.

If investors believe that a company will go bankrupt, the price of their debentures unsurprisingly goes down to their expected recovery amounts. This happened to both Zargon and Twin Butte. A little over a year ago, the debentures of both companies were priced below 30% of their face values.

However, I didn’t think the debentures were priced correctly. My models of both companies told me that their recovery amounts were significantly higher than implied in the price of those debentures. So a little over a year ago, I bought Zargon debentures at roughly 35% of face value, and I bought Twin Butte debentures at roughly 14% of face value. I put the debentures in my RRSP account, so my TFSA balance doesn’t reflect these investments. As an aside, I didn’t recommend these investments to anyone else because these were penny stocks, and I have a personal policy against recommending penny stocks.

The great thing about investing in debentures, as opposed to stocks, is that there is a mechanism that forces their prices to their correct values. A stock price can remain undervalued for long periods of time, if other investors either don’t see the true value of the stock, or if they remain convinced that the stock will stay undervalued. While there are potential “catalysts” that can correct the value of a stock (e.g. acquisition offers from rival companies who see the true value), investors generally can’t count on such catalysts occurring.

With debentures, however, there is always a clear catalyst. When a debenture matures, the debenture holder either receives the face value when the company can come up with enough cash, or the recovery amount when the company doesn’t have the cash and goes bankrupt.

In the case of both Zargon and Twin Butte, the catalysts were not very far away. Zargon debentures were scheduled to mature in June 2017 (they’ve been redeemed since), and Twin Butte debentures were scheduled to mature in December 2018. This seemed like a perfect way, then, not just to make money but to test whether my valuation models had any substance.

Thankfully, the events that followed seemed to support my models. After I made the purchase, Zargon sold some of its oil and gas assets for a good price that was somewhat consistent with my model’s valuation. The asset sale gave investors confidence that Zargon would be able to stave off bankruptcy, and so debenture prices went up from 35% of face value to over 90% of face value in the space of a year. I sold my debentures for more than 90% a few months ago.

In the case of Twin Butte, the story was a lot messier. The company realized it wasn’t able to pay back the debenture holders, so it tried to strike a deal where it would sell its assets and distribute some money to both its debenture holders and shareholders.

Unfortunately, the deal that the company proposed to its debenture holders was not well received. Under the deal, debenture holders would have collectively received $12 million, whereas shareholders, who were behind the debenture holders in pecking order, would have collectively received $21 million. The debenture holders rejected the deal and the company went into receivership, which is akin to bankruptcy.

The receivership process took many months. The receiver followed a methodical process to solicit bids for Twin Butte’s assets, and then to figure out how much to repay its creditors once the sale went through. While the process hasn’t concluded yet, the signs are very encouraging. According to the receiver, Twin Butte debenture holders should receive a minimum of 57% of the face value, and quite possibly more. This was again somewhat consistent with my valuation model.

I’m not writing about my winnings to brag. Rather, I’m writing about them because they provide evidence that my valuation models are at least somewhat correct. Some people who follow my blog may wonder if I’m holding onto my losing oil and gas stocks for too long. They may think that, but I’m not going to change my investments just because they’ve been losing. My models show that my oil and gas stocks are very significantly undervalued. I will keep following the direction of my models, because that’s what being a value investor is all about.

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